Are traditional stock valuation methods holding you back from maximizing your profits?
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Hi all,
In today’s video, we discuss valuations — what they are and their relevance in stock trading and investing.
Valuation is a complex and often subjective concept that varies significantly depending on the context. For instance, consider a Coke bought from a discount store versus one consumed in a luxury hotel room. Both serve the same purpose of quenching thirst, yet their prices can differ dramatically, sometimes by several multiples. This disparity arises because of the added service element provided by the hotel. Whether this added service justifies the higher price is subjective.
Some may view the comfort and convenience as worth the premium, while others might find it excessive, reasoning they could simply buy the same Coke at a lower price and enjoy it in the hotel room.
This principle translates well to stock markets. A buyer and seller may agree on a transaction price, yet their perceptions of value can vary widely. For example, the buyer might view the stock as a bargain, expecting its price to rise, while the seller may see it as overvalued and decide to offload it.
A recent example of a stock that divided opinion is Palantir. In August 2024, the stock had a Price-to-Earnings (PE) ratio of 70, compared to the average PE ratio of 28 for tech stocks in the S&P 500. By conventional standards, this would have made Palantir appear expensive. Even Stockopedia assigned it a value score of just 2 out of 100, indicating it was far from a value investor's dream.
At the beginning of August, the stock was priced at $30. However, just four months later, it had soared to $80, with its PE ratio skyrocketing to 170. This demonstrates how relying solely on traditional valuation metrics like the PE ratio could have kept you out of significant gains in such a high-growth stock.
For traders like me, valuations are not the central focus. My goal is often to identify quality momentum stocks at the right time and ride the trends. However, for value investors, valuations are a cornerstone of their strategy. Let’s explore other methods investors use to value stocks.
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There are three main methods that investors use to value stocks: asset-based, income-based, and market-based approaches.
The asset-based approach uses the net asset value (NAV) of a company to determine its stock value. NAV is calculated by subtracting a company’s liabilities from its assets, as shown on the balance sheet. This NAV, also referred to as the book value, represents the company’s worth after paying off its obligations. When divided by the number of outstanding shares, it gives the book value per share, which can then be compared to the stock price.
The resulting Price-to-Book-Value (PBV) ratio is a key metric. A lower PBV typically indicates undervaluation, while a higher PBV suggests overvaluation. For example, a PBV of less than 1 means the stock is trading below its NAV. Value investors often hunt for such stocks, betting that their prices will eventually converge with their intrinsic value. Warren Buffett, one of the greatest value investors of all time, built much of his early fortune by investing in stocks trading below their book value.
The income-based valuation method discounts a company’s expected future earnings, cash flows, or dividends to their present value to determine fair value. For instance, if a company is expected to pay $5 per share in perpetuity, its fair value can be calculated using a perpetual discounting formula. Using a 10% discount rate, the stock’s value would be $50.
This method takes into account the inherent risk in the company and its operations. The discount rate is determined by adding a risk premium to the risk-free rate (typically government bond yields). Higher-risk businesses warrant a higher discount rate, which lowers the fair value. Conversely, safer or more stable companies can justify lower discount rates, leading to higher valuations.
Additionally, economic conditions can affect these rates. In risk-averse markets, discount rates tend to rise, depressing valuations. In more optimistic or growth-oriented environments, investors may be willing to accept lower risk premiums, thereby increasing valuations.
The market-based approach compares a company’s metrics to those of similar businesses to determine its valuation. The Price-to-Earnings (PE) ratio is the most commonly used metric in this method. It is calculated by dividing the stock price by the company’s earnings per share (EPS). The resulting multiple is then compared with industry averages or peer companies to gauge the stock's relative value, just as we saw with the Palantir example earlier.
For example, if an automotive company trades at a PE of 10x while the industry average is 15x, the company may be considered undervalued relative to its peers. Other common metrics include Price-to-Sales, Price-to-Operating Profit, and Price-to-Cash Flow ratios.
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The difference between price and value is critical to understanding valuations. As illustrated by the Coke example, price often reflects market conditions and external factors, while value represents the inherent worth of the item. Similarly, in the stock market, price and value often diverge.
Benjamin Graham, Warren Buffett’s mentor, famously introduced the concept of "Mr. Market" to explain this phenomenon. According to Graham, Mr. Market is an emotional entity, sometimes offering stocks at bargain prices when pessimistic and at inflated prices when euphoric. Value investors thrive during pessimistic periods — bear markets or corrections — when prices fall below intrinsic values. Conversely, in euphoric markets, stocks often trade at premiums that limit their upside potential.
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Valuations have long been central to investment decisions, particularly for institutional investors. However, their relevance has shifted in recent years, especially for companies in high-growth or transformative industries.
For instance, companies like Amazon, Tesla, and Uber achieved sky-high market caps despite low book values or earnings during their growth phases. Investors focused on their potential to dominate industries rather than current financial metrics. Similarly, biotech firms working on groundbreaking treatments, such as cancer drugs, may command high valuations due to the enormous potential of their innovations.
Growth is another critical factor. Even within the same industry, companies with faster revenue and earnings growth often command higher valuations than slower-growing competitors.
Let’s take Tesla as our example. Using August 2024 as the starting point for analysis, the stock had a Price-to-Earnings (PE) ratio of 76—significantly higher than the market average. Stockopedia also rated Tesla poorly, assigning it a valuation score of just 5 out of 100. By all traditional valuation metrics, both against the broader market and its industry peers, Tesla appeared expensive.
However, the company’s fundamentals told a different story. Tesla demonstrated strong revenue growth, boasting a compound annual growth rate (CAGR) of 35%.
At that time, the stock was priced at $206. Just over four months later, it had more than doubled, reaching $454. Investors who relied solely on valuation as a catalyst for entry would have missed out on yet another substantial growth opportunity.
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In my trading strategy, valuations take a backseat. Instead, I prioritize identifying quality growth stocks with strong momentum, often breaking out of consolidation. To assess quality, I rely on fundamental metrics like return on equity, operating margins, revenue growth, earnings growth, and manageable debt. My custom scanner helps me evaluate these parameters efficiently.
Momentum is the key focus of my approach. I look for quality stocks that are already trending upwards. These stocks may appear expensive based on traditional valuation metrics, but their strong growth potential, just like the Tesla example, often justifies the premium.
By contrast, undervalued stocks are often cheap for a reason. Persistent headwinds or structural challenges can keep these stocks underpriced for extended periods. While some investors excel at identifying and profiting from such opportunities, it’s not my strength. I have honed my skills in identifying and riding momentum, which has consistently delivered strong results for me over the years.
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While valuations remain theoretically important, their practical relevance varies depending on the company and market conditions. For businesses in their early stages or those investing in disruptive technologies, traditional metrics may not capture their full potential. Instead, investors focus on the long-term value these companies can create.
Market sentiment also plays a significant role. During periods of heightened risk aversion, valuation metrics become stricter, and investors demand higher risk premiums. Conversely, in bullish or growth-oriented markets, investors are often willing to pay premiums for high-potential companies.
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Valuations are a nuanced and multifaceted concept. For value investors, they are the foundation of their strategy, guiding them to find bargains in the market. For traders like me, valuations are less critical compared to factors like quality, momentum, and technical trends.
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